Ichiro Fukunaga Research and Statistics Department Bank of Japan 28 October 2009 in Jerusalem

1. A Discussion on “Introducing Financial Frictions and Unemploymentinto a Small Open Economy Model”(Christiano, Trabandt, and Walentin) Ichiro Fukunaga Research and Statistics Department Bank of Japan 28 October 2009in Jerusalem

2. Outline • Summary • Comments • Discussions(questions and suggestions)

3. Summary (1):model overview • Based on small open economy model of Adolfson, Laseen, Linde, and Villani. • Introducing financial frictionsfollowing Bernanke, Gertler, and Gilchrist,and Christiano, Motto, and Rostagno. • Introducing labor market search and matching framework ofMortensen and Pissarides,Gertler, Sala, and Triagari, etc.

4. Summary (2):baseline small open economy • Calvo price setting in both export & import. • Exchange rate shocks take time to pass into domestic prices. • Hump-shaped response of output and exchange rate to a monetary policy shock. • Uncovered interest rate parity • Unit-root investment technology shock • Careful treatment of capital income tax

5. Summary (3):financial frictions • Asymmetric information between “entrepreneurs” and banks. • Entrepreneurs have a special skill in operation and management of capital. • Capital stock includes both housing and business capital. • Interest rate is nominally not state-contingent. >> Fisher effects

6. Summary (4):labor market frictions • Wage setting frictions (Taylor-type) >> not have a direct impact on on-going employment relations but on recruiting. • Labor services are supplied to labor market by “employment agencies.” • Wage is determined by Nash bargaining. • Endogenous separation of employment from their jobs. • Symmetry in modeling idiosyncratic shocks

7. Summary (5):estimation results • Bayesian estimation using Swedish data from 1995Q1 to 2008Q1. • Among 19 shocks, neutral tech. shock is important for both output and inflation,Wealth shock drives 3/4 of investment.Spillover of financial shocks to unemploymt. • IRFs of model with unemployment is similar to those of EHL model. • Monetary policy shocks are amplified by financial frictions.

8. Comments (1):financial frictions • Modest effects of financial frictions.-- Only operation of capital involves frictions. (Working capital loans are frictionless).-- Entrepreneurs don’t have assets.>> In BGG, they have assets and sell output to Calvo-pricing retailers. • Too much effects of nominal debt contract?-- It dampens output/investment responses to supply shocks.

9. Comments (1):financial frictions (cont.) • External finance premium is not“risk premium.” -- just compensation for monitoring cost. -- Both borrowers and lenders are risk-neutral under debt contract.>> Where’s “true” risk premium? • Data for entrepreneurs’ “net worth.” -- could be broader than stock market.-- includes collateral value of illiquid assets.

10. Comments (2):labor market frictions • Similar effects to EHL (sticky wage model).-- Little effects of unemployment?-- Passive role of “employment agency.” • Alternative formulations of bargaining.-- Which formulation is better?>> can be decided in terms of marginal likelihood. cf. Ichiue, Kurozumi, and Sunakawa (2008, Bank of Japan WP)

11. Comments (3):estimation • Real variables are log-differenced and demeaned.-- consistent with two-sector growth model? • Measurement errors for most variables.-- really needed?-- identification problems (markup shocks)

12. Discussions (1):practical uses • Forecasting performance-- improved compared with Ramses?-- better than BVAR? • Policy simulations-- monetary policy rule reacting to credit spread-- tax policies-- welfare evaluation among heterogeneous agents: difficulty?

13. Discussions (2):potential output and output gap • In a simple sticky price/wage model,estimated potential (=efficient/natural) output tends to be too volatile. • In this model with many real frictions,estimated potential (=efficient) outputmay be reasonably smooth.--- Output gap, in turn, may be volatile reflecting real frictions.